CHAPTER 14

Financial Planning and

Forecasting Financial
Statements

1
Topics
Financial Statements 101
Ratio Analysis
Financial Planning and Forecasting
AFN
Percent of Sales Method

2
Three Financial
Statements

Balance Sheet
Income Statement
Cash Flow Statement

3
Balance Sheet of The firm (Snap Shot of the
Current Assets have a
Firm) life of less than 1 year
and include:
Shareholders Equity = Assets - Liabilities
Cash
Account receivable
Inventory

Assets = Liabilities + Shareholders Equity

Current Liabilities have a

life of less than 1 year Bank loans
and include: Machine, Equipment
Long-term
Short-term liability borrowings
Patents
Accounts Payable
CA - CL

4
 Duke Corp.: Balance Sheet
(Assets) 20082009
Cash 9,000 7,282
S-T invest. 48,600 20,000
AR 351,200 632,160
Inventories 715,200 1,287,360
Total CA 1,124,000 1,946,802
Gross FA 491,000 1,202,950
Less: Depr. 146,200 263,160
Net FA 344,800 939,790
Total assets 1,468,800 2,886,592
5
 Balance Sheet: Liabilities &
Equity 2008 2009
Accts. payable 145,600 324,000
Notes payable 200,000 720,000
Accruals 136,000 284,960
Total CL 481,600 1,328,960
Long-term debt 323,432 1,000,000
Common stock 460,000 460,000
Ret. earnings 203,768 97,632
Total equity 663,768 557,632
Total L&E 1,468,800 2,886,592 6
What effect did the expansion
have on the asset section of the
balance sheet?
Net fixed assets almost tripled in
size.
AR and inventory almost doubled.
Cash and short-term investments
fell.

7
 Liquidity of Assets
The order of assets on the balance sheet reflects
their liquidity. (decreasing order of liquidity)
Liquidity is the speed at which the asset can be
converted to cash with little or no loss in value
Liquid firms are less likely to experience
financial distress
But, liquid assets earn a lower return
Liquid Assets
Account receivable and possibly inventory
Non-liquid Assets
specialized fixed asset (e.g., equipment) and intangible
assets (e.g., patents and trademarks)
8
 Book Value vs. Market
Value
Find the book value.
Historical cost
Recorded amount in financial statements
GAPP says You record historical cost!
Find the market value.
More important
True value of the firm
The amount of cash we would get if we
actually sell the firm now.
Is NOT on the financial statements
Replacement value 9
 Income Statement
(Example) 2008 2009
Sales 3,432,000 5,834,400
COGS 2,864,000 4,980,000
Other expenses 340,000 720,000
Deprec. 18,900 116,960
Tot. op. costs 3,222,900 5,816,960
EBIT 209,100 17,440
Int. expense 62,500 176,000
EBT 146,600 (158,560)
Taxes (40%) 58,640 (63,424)
Net income 87,960 (95,136)
10
What happened to sales
and net income?
Sales increased by over $2.4 million.
Costs shot up by more than sales.
Net income was negative.
However, the firm received a tax
refund since it paid taxes of more
than $63,424 during the past two
years.

11
 GAAP Allows Accrual Basis
Accounting!
Matching principle: GAAP says to show revenue
when it accrues and match the expenses required
to generate the revenue
Realization Principle: GAAP says to recognize
revenue when the earnings process is virtually
complete and the value of an exchange of goods
or services is known or can be reliably determined.
What does this mean?
Records revenue when it is earned, whether or not the
revenue has been received in cash.
Records expense when they are incurred, even if the
money has not actually been paid out.
12
 Profits and cash flows are
not the same thing!
The potential problem with GAAP to
understand the firms financial condition
Mismatch between the time when the
income (cost) is realized and the time when
the revenue (cost) is collected
This is because GAAP requires that sales be
recorded on the income statement when
made, not when cash is received
GAAP also requires that we record cost of
goods sold when the corresponding sales
are made, regardless of whether we have
actually paid our suppliers yet
13
Noncash items
A typical noncash item is depreciation
expense
Hypothetical number
Noncash items are irrelevant to firm
valuation in general because they do not
represent true cash inflow or outflow
However, noncash items are still important
to understand the firms financial condition
because they affect the firm's tax liability
(and, therefore, cash flow)
14
 So, what can we conclude?
The accrual accounting and noncash
items results in inequality between cash
flows and net income (or earnings).
Finance Emphasizes the Importance of
Timing
Timing of Cash Flow Matters
Accrual Accounting May Obscure Timing
You Cant Deposit Net Income, Only Cash
Therefore, we must present cash flow
statement to understand the firms
financial condition better.
15
 The Sources and Uses of
Corporate Cash
Sources Uses

Decrease in any Increase in any asset

asset Decrease in any liability
Increase in any Net loss
liability
Dividends paid
Net profits after
taxes
Repurchase or
retirement of stock
Depreciation and
other non-cash
charges
Sale of stock
16
Statement of Cash Flows:
2009
Operating Activities
Net Income (95,136)
Adjustments:
Depreciation 116,960
Change in AR (280,960)
Change in inventories (572,160)
Change in AP 178,400
Change in accruals
148,960
Net cash provided by ops.
(503,936) 17
Long-Term Investing Activities
Cash used to acquire FA (711,950)

Financing Activities
Change in S-T invest. 28,600
Change in notes payable 520,000
Change in long-term debt676,568
Payment of cash dividends (11,000)
Net cash provided by fin. act.1,214,168

18
 Summary of Statement of
CF
Net cash provided by ops.
(503,936)
Net cash to acquire FA (711,950)
Net cash provided by fin. act.1,214,168
Net change in cash (1,718)
Cash at beginning of year
9,000
Cash at end of year 7,282 19
 What can you conclude
from the statement of
cash flows?
Net CF from operations = -$503,936,

because of negative net income and

increases in working capital.
The firm spent $711,950 on FA.
The firm borrowed heavily and sold
some short-term investments to
meet its cash requirements.
Even after borrowing, the cash
account fell by $1,718.
20
EDGAR
EDGAR stands for Electronic Data
Gathering, Analysis and Retrieval system.
Since May 6, 1996, the SEC has required all
domestic public companies to post their
filings on EDGAR.
EDGAR includes the annual reports known
as 10-Ks and the quarterly reports known
as 10-Qs, as well as proxy.
Go to www.sec.gov

21
 Why Evaluate Financial
Statements?
Internal uses
Performance evaluation compensation
and comparison between divisions
Planning for the future guide in
estimating future cash flows
External uses
Creditors
Suppliers
Customers
Stockholders
22
Why are ratios useful?
Standardize numbers; facilitate
comparisons
Used to highlight weaknesses and
strengths

23
24
Five Major Categories of
Ratios
Liquidity: Can we make required
payments as they fall due?
Asset management: Do we have the right
amount of assets for the level of sales?
Debt management: Do we have the right
mix of debt and equity?
Profitability: Do sales prices exceed unit
costs, and are sales high enough as
reflected in PM, ROE, and ROA?
Market value: Do investors like what they
see as reflected in P/E and M/B ratios?
25
 Calculate and appraise the
P/E.

Price = $12.17.
NI $253.6
EPS = Shares out. = 250 = $1.01.

Price per share $12.17

P/E = EPS = $1.01 = 12x.

26
 Price-Earning Ratio
If PE ratio =10, then we would say the
company's stock sell for 10 times earnings.
PE ratio measures how much investors are
willing to pay per dollar of current earnings.
The higher the PE ratio is, the higher the firms
growth prospects would be in the future.
Growth Stock= stocks with relatively higher PE ratio
(e.g., Tech stocks)
Value stock= stocks with relatively lower PE ratio (e.g.,
Utility stocks)
Watch out: If the firm generates almost no
earnings, then PE ratio could be very large.
(Why?) So, care is needed in interpreting this
ratio 27
 Industry P/E Ratios
Industry Ticker* P/E
Banking STI 16.43
Software MSFT 31.59
Drug PFE 22.56
Electric DUK 20.04
Utilities
Semiconductor INTC 28.38
s
Steel NUE 13.03
Tobacco MO 13.25
28
S&P 500 21.52
 Benchmarking
Ratios are not very helpful by themselves; they
need to be compared to something
Time-Trend Analysis
one-year ratios do NOT provide a full picture
Used to see how the firms performance is changing
through time
Do multi-year analysis
Peer Group Analysis
Compare to similar companies or within industries
SIC and NAICS codes (http://www.naics.com/)
Should be used in conjunction with other
qualitative measurements. For example,
heterogeneity in accounting practice, market
structures, customer bases, capital structures, etc.
29
Peer Group Analysis:
Advanced Micro Device (AMD)

30
Financial Forecasting
Financial planning
Additional Funds Needed (AFN)
formula
Pro forma financial statements
Sales forecasts
Percent of sales method

31
Financial Planning and Pro
Forma Statements
Three important uses:
Forecast the amount of external
financing that will be required
Evaluate the impact that changes in
the operating plan have on the value
of the firm
Set appropriate targets for
compensation plans

32
Steps in Financial
Forecasting
Forecast sales
Project the assets needed to support
sales
Project internally generated funds
Project outside funds needed
Decide how to raise funds
See effects of plan on ratios and stock
price
33
 2007 Balance Sheet
(Millions of $)

Cash & sec. $ 20 Accts. pay. &

accruals $ 100
Accounts rec. 240 Notes payable 100
Inventories 240 Total CL $ 200
Total CA $ 500 L-T debt 100
Common stk 500
Net fixed Retained
assets 500 earnings 200
Total assets $1,000 Total claims $1,000

34
2007 Income Statement
(Millions of $)

Sales $2,000.00
Less: COGS (60%) 1,200.00
SGA costs 700.00
EBIT $ 100.00
Interest 10.00
EBT $ 90.00
Taxes (40%) 36.00
Net income $ 54.00
Dividends (40%) $21.60
Addn to RE $32.40
35
AFN (Additional Funds
Needed):
Key Assumptions
Operating at full capacity in 2007.
Each type of asset grows proportionally
with sales.
Payables and accruals grow
proportionally with sales.
2007 profit margin ($54/$2,000 = 2.70%)
and payout (40%) will be maintained.
Sales are expected to increase by $500
million.

36
Definitions of Variables in
AFN
A*/S0: assets required to support
sales; called capital intensity ratio.
S: increase in sales.
L*/S0: spontaneous liabilities ratio
M: profit margin (Net income/sales)
RR: retention ratio; percent of net
income not paid as dividend.
37
 Assets vs. Sales
Assets
Assets = 0.5 sales
1,250
Assets =
(A*/S0)Sales
1,000
= 0.5($500)
= $250.

Sales
0 2,000 2,500
A*/S0 = $1,000/$2,000 = 0.5 = $1,250/$2,500. 38
AFN= Required - Spontaneous - Retained
Assets Liabilities Earnings
Required Asset to Sales
= x Sales
Assets Ratio
= 0.500 x $500.00
= $250.00
Spontaneous
Spontaneous = Liab. to Sales x Sales
Liabilities Ratio
= 0.050 x $500.00
= $25.00
Retained Retention
= Profit Margin x Sales x
Earnings Ratio
= 0.027 x $ 2,500.0 x 0.600
= $40.50

AFN= Required - Spontaneous - Retained

Assets Liabilities Earnings
= $250.00 - $25.00 - $40.50
AFN= $184.50 39
If assets increase by $250
million, what is the AFN?
AFN = (A*/S0)S - (L*/S0)S - M(S1)(RR)

AFN = ($1,000/$2,000)($500)
- ($100/$2,000)($500)
- 0.0270($2,500)(1 - 0.4)

AFN = $184.5 million.

40
How would increases in
these items affect the
AFN?
Higher sales:
Increases asset requirements,
increases AFN.
Higher dividend payout ratio:
Reduces funds available internally,
increases AFN.

(More)
41
 Higher profit margin:
Increases funds available internally,
decreases AFN.
Higher capital intensity ratio, A*/S0:
Increases asset requirements, increases
AFN.
Pay suppliers sooner:
Decreases spontaneous liabilities, increases
AFN.

42
Projecting Pro Forma
Statements with the Percent
of Sales Method
Project sales based on forecasted
growth rate in sales
Forecast some items as a percent
of the forecasted sales
Costs
Cash
Accounts receivable
(More...)
43
 Items as percent of sales (Continued...)
Inventories
Net fixed assets
Accounts payable and accruals
Choose other items
Debt
Dividend policy (which determines retained
earnings)
Common stock
44
Sources of Financing Needed
to Support Asset
Requirements
Given the previous assumptions
and choices, we can estimate:
Required assets to support sales
Specified sources of financing
Additional funds needed (AFN) is:
Required assets minus specified
sources of financing

45
Implications of AFN
If AFN is positive, then you must
secure additional financing.
If AFN is negative, then you have
more financing than is needed.
Pay off debt.
Buy back stock.
Buy short-term investments.

46
How to Forecast Interest
Expense
Interest expense is actually based on
the daily balance of debt during the
year.
There are three ways to approximate
interest expense. Base it on:
Debt at end of year
Debt at beginning of year
Average of beginning and ending debt

More
47
Basing Interest Expense
on Debt at End of Year
Will over-estimate interest expense
if debt is added throughout the
year instead of all on January 1.
Causes circularity called financial
feedback: more debt causes more
interest, which reduces net income,
which reduces retained earnings,
which causes more debt, etc.
More
48
Basing Interest Expense
on Debt at Beginning of
Year
Will under-estimate interest
expense if debt is added
throughout the year instead of all
on December 31.
But doesnt cause problem of
circularity.

More
49
Basing Interest Expense on
Average of Beginning and
Ending Debt
Will accurately estimate the
interest payments if debt is added
smoothly throughout the year.
But has problem of circularity.

More
50
A Solution that Balances
Accuracy and Complexity
Base interest expense on beginning
debt, but use a slightly higher
interest rate (say, 0.5% higher).
Easy to implement
Reasonably accurate
See Ch 14E Toolkit.xls for an
example basing interest expense
on average debt.

51
Percent of Sales: Inputs
2007
Actual 2008 Proj.
COGS/Sales 60% 60%
SGA/Sales 35% 35%
Cash/Sales 1% 1%
Acct. rec./Sales 12% 12%
Inv./Sales 12% 12%
Net FA/Sales 25% 25%
AP & accr./Sales 5% 5%52
Other Inputs
Percent growth in sales 25%

Growth factor in sales (g) 1.25

Interest rate on debt 10%

Tax rate 40%

Dividend payout rate 40%

53
2008 First-Pass Forecasted
Income Statement
Calculations 2008 1st Pass
Sales 1.25 Sales07 = $2,500.0
Less: COGS 60% Sales08 = 1,500.0
SGA 35% Sales08 = 875.0
EBIT $125.0
Interest 0.1(Debt07) = 20.0
EBT $105.0
Taxes (40%) 42.0
Net Income $63.0
Div. (40%) $25.2
Add to RE $37.8
54
2008 Balance Sheet
(Assets)
Calcuations 2008
Cash 1% Sales08 = $25.0
Accts Rec. 12%Sales08 = 300.0
Inventories 12%Sales08 = 300.0
Total CA $625.0
Net FA 25% Sales08 625.0
=
Total Assets $1,250.0
55
 2008 Preliminary Balance
Sheet (Claims)
5 Calculation 2008 Without
s AFN
AP/accruals 5% Sales08 $125.0
=
Notes 100 Carried 100.0
payable over
Total CL $225.0
L-T debt 100 Carried 100.0
over
Common stk 500 Carried 500.0
over 56
What are the additional
funds needed (AFN)?
Required assets = $1,250.0
Specified sources of fin. = $1,062.8
Forecast AFN: $1,250 - $1,062.8 =
$187.2
NWC must have the assets to make
forecasted sales, and so it needs an
equal amount of financing. So, we
must secure another $187.2 of
financing.
57
Assumptions about how AFN
will
be raised
No new common stock will be
issued.
Any external funds needed will be
raised as debt, 50% notes payable,
and 50% L-T debt.

58
How will the AFN be
financed?
Additional notes payable
=0.5 ($187.2) = $93.6.

Additional L-T debt

= 0.5 ($187.2) = $93.6.

59
2008 Balance Sheet
(Claims)

w/o AFN AFN With AFN

AP accruals $125.0 $125.0
Notes 100.0 +93.6 193.6
payable
Total CL $225.0 $318.6
L-T Debt 100.0 +93.6 193.6
Common stk 500.0 500.0
Ret earnings 237.8 237.8
Total claims $1,062. $1250.0
60
Equation AFN = $184.5 vs.

Pro Forma AFN = $187.2.

Equation method assumes a
constant profit margin.
Pro forma method is more flexible.
More important, it allows different
items to grow at different rates.

61
 Forecasted Ratios
2007 2008(E) Industr
y
Profit Margin 2.70% 2.52% 4.00%
ROE 7.71% 8.54% 15.60%
DSO (days) 43.80 43.80 32.00
Inv turnover 8.33x 8.33x 11.00x
FA turnover 4.00x 4.00x 5.00x
Debt ratio 30.00% 40.98% 36.00%
TIE 10.00x 6.25x 9.40x 62
 What are the forecasted
free cash flow and ROIC?
2007 2008(E)
Net operating WC $400 $500
(CA - AP & accruals)
Total operating capital $900 $1,125
(Net op. WC + net FA)
NOPAT (EBITx(1-T)) $60 $75
Less Inv. in op. capital $225
Free cash flow -$150
ROIC (NOPAT/Capital) 6.7%
63
Proposed Improvements
Before After
DSO (days) 43.80 32.00

Accts. rec./Sales 12.00% 8.77%

Inventory turnover 8.33x 11.00x
Inventory/Sales 12.00% 9.09%
SGA/Sales 35.00% 33.00%

64
Impact of Improvements
(see Ch 14 Mini Case.xls
for details)
Before After

AF $187.2 $15.7

Free cash flow -$150.0 $33.5

ROIC (NOPAT/Capital) 6.7% 10.8%

ROE 7.7% 12.3%

65
If 2007 fixed assets had
been operated at 75% of
capacity:
Actual sales
Capacity sales =
% of capacity
$2,000
= = $2,667.
0.75

With the existing fixed assets, sales

could be $2,667. Since sales are
forecasted at only $2,500, no new
fixed assets are needed.
66
How would the excess
capacity situation affect the
2008 AFN?
The previously projected increase
in fixed assets was $125.
Since no new fixed assets will be
needed, AFN will fall by $125, to:

$187.2 - $125 = $62.2.

67
 Economies of Scale

1,100
1,000

Declining A/S Ratio
Assets

Base
Stock

Sales
0 2,000 2,500
$1,000/$2,000 = 0.5; $1,100/$2,500 = 0.44. Declining ratio shows
economies of scale. Going from S = $0 to S = $2,000 requires $1,000 of
assets. Next $500 of sales requires only $100 of assets. 68
 Lumpy Assets

1,500
Assets

1,000

500

Sales
500 1,000 2,000
A/S changes if assets are lumpy. Generally will have excess
capacity, but eventually a small S leads to a large A. 69
Summary: How different
factors affect the AFN
forecast.
Excess capacity: lowers AFN.
Economies of scale: leads to less-
than-proportional asset increases.
Lumpy assets: leads to large
periodic AFN requirements,
recurring excess capacity.

70